Chris Mercer’s Value Matters newsletter offered a succinct summary of the Eleventh Circuit’s recent decision in Jelke v. Com., an important decision dealing with built-in capital gains (BIG) tax liability of Subchapter C corporations. The subject company in the case was a C corporation established 80 years ago, whose principal asset was an investment portfolio managed for long-term capital growth. The company was valued for estate tax purposes, and the decedent’s expert discounted the net asset value by $51.6 million tax liability, assuming liquidation of the investment portfolio. The IRS took the position that liquidation was not imminent, and spread out the tax liability over 16.8 years (which was consistent with the slow rate of asset turnover). Discounting the future tax liability back to its net present value, the IRS estimated the tax liability at $21.0 million. The Tax Court adopted the IRS position, and the taxpayer appealed.

The Eleventh Circuit Court of Appeals employed the principal of substitution in its analysis, wondering why a hypothetical buyer would choose to purchase an interest in a corporation with BIG tax liabilities when the buyer could simply buy the underlying stocks in the market. The Eleventh Circuit court held that liquidation was the proper assumption when determining net asset value, and sided with the taxpayer by discounting the corporation’s value for the entire tax liability.

This decision might be persuasive in the divorce courts of Pennsylvania, where hypothetical tax consequences may be considered in determining the value of marital assets. Were the divorce court faced with the valuation of a C corporation having BIG tax liability, it might be appropriate to subtract the tax liability from the company’s net asset value. The market alternative for an interest in a corporation having BIG tax would be the underlying assets themselves without tax liability, according to Jelke.

This post is the second in a series dedicated to historical legal precedents on business valuation in Pennsylvania. The factual background for this case, Glosser Bros., is discussed in my post last week. This is part II:

In addition to their argument that trial court should have considered actual stock transactions, the appellants in Glosser Bros. also complained about the expert testimony given by the dissenters’ accountant, who calculated the company’s net asset value. In particular, the Company argued that the trial court should have excluded the expert’s testimony to the extent that he had relied upon an equipment appraisal prepared by an appraiser (at the Company’s request) who did not testify at trial. The Company also complained that the plaintiffs’ accountant was not qualified to determine the value of leases held by the Company.

The dissenting shareholders argued that their expert’s testimony about the equipment appraisal was admissible, despite being hearsay, because it had been relied upon by the Company in its proxy statement for the merger and considered by management in adopting a certain tax treatment of the transaction. As such, they argued, it was an adoptive admission of the Company. Furthermore, the dissenters argued, it was the type of evidence on which business valuation professionals generally rely in the practice of their profession, and thus admissible under Pa.R.E. 703.

The trial court, apparently, had repeated the refrain frequently heard by lawyers who object to the admission of evidence: that the evidence would be admitted and the court would decide what weight to assign to it. The Superior Court generally approved this ruling, noting that in non-jury trials, it might be desirable for the trial court to have as much evidence before it as possible.

The Superior Court first rejected the Company’s argument that the dissenters’ expert was not qualified to appraise the leases. Observing that the accountant had been qualified as an expert on the issue of stock valuation, the Superior Court cited Pennsyvlania’s liberal standard for qualification of an expert. The Court also noted that the Company itself had used the same methods for its own purposes. Therefore, the Superior Court refused to disqualify the dissenters’ expert on this issue.

As for the equipment appraisal on which the business valuator relied, the Superior Court agreed that it would be hearsay evidence if offered to prove the truth of the matters that it contained. The Superior Court held that the Company’s use and reliance on the equipment appraiser’s opinion did not amount to an adoptive admission. Yet, the Superior Court did not overrule the trial court’s decision to admit the testimony of the plaintiff’s valuation expert, including the portions of his testimony that relied upon the hearsay equipment appraisal.

Reviewing the development of evidentiary procedure, the Superior Court noted that the expert testimony exception to the hearsay rule had been extended beyond medical experts, to experts in other fields. See, e.g., Pittsburgh Outdoor Advertising Corp. Appeal, 440 Pa. 321, 272 A.2d 163 (1970); Steinhauer v. Wilson, 485 A.2d 477 (Pa.Super.1984). Yet, the Superior Court in Glosser Bros. placed significant weight on the fact that the equipment appraisal had been prepared for the Company itself and was not the only equipment appraisal that the plaintiff’s valuation expert had considered. The testifying expert had exercised his own independent judgment by giving greater weight to the out-of-court equipment appraisal than to another appraisal prepared by an expert who testified at trial. Finding that the equipment appraisal carried its own “circumstantial guarantee of trustworthiness,” the Superior Court refused to exclude the testimony of the plaintiff’s business valuation who relied on the hearsay evidence.

This post is the first of series aimed at reviewing the historical legal decisions concerning business valuation in Pennsylvania. Since these are state court cases, most arise from shareholder disputes, divorces, and condemnation cases. Some are stale, some vital, and some questionable, but all are worth reviewing. The first installment, concerning Glosser Bros., will be presented in two parts:

One of the leading cases on business valuation in Pennsylvania is In re Glosser Bros., Inc., 555 A.2d 129 (Pa.Super.1989), a dissenting shareholder action arising from the management-led buyout of a regional chain of discount department stores, outlet stores and grocery stores. Three of the company’s shareholders filed suit against the acquirer, claiming that the share price paid by acquirer was too low and seeking an appraisal of the stock. The standard of value in such cases is “fair value” as provided by Section 515 of the Pennsylvania Business Corporation Law of 1988.

Glosser Brothers was a publicly-traded stock listed on the American Stock Exchange. In the months immediately preceding the merger, the shares traded around $14 per share. The stock had never traded for more than $19 per share. The company that acquired Glosser Brothers in 1985 paid $20 per share.

The Cambria County trial court did not appoint an appraiser, but took expert testimony about the methods of determining fair value, including net asset value and investment value. The trial court found the stock was worth $31 per share, which was determined by assigning 65% weight to the company’s net asset value and 35% weight to its investment value. The company appealed on several grounds, including the trial court’s refusal to consider its market share price.

The Superior Court agreed that it was an error to disregard the price at which the stock traded on the American Stock Exchange. The Court cited back to O’Connor Appeal, 452 Pa. 287, 304 A.2d 694 (1973), which required the courts in shareholder appraisal actions to consider actual market value as well as net asset value and investment value. The Court also held that the traditional “Delaware block” method of valuation (in which the court would only consider the three traditional methods of valuation, assigning a percentage weight to each) would yield to a broader consideration of generally accepted valuation techniques. (Business valuation was, at that time, a new and developing science.)

The Superior Court held that market value, while relevant, was not controlling. While it might be deemed extremely reliable in cases where there were many transactions providing extensive data, it might be less reliable in cases where the transactions were few and data scarse. Still, the Court held that market value should be totally disregarded only in cases where there was competent and substantial evidence to support the conclusion that the value at which the stock is trading is not at all reliable in gauging its intrinsic going concern value. For instance, where a high percentage of shares is held by an individual or small group, or thinly traded, the market value might be deemed unreliable.

The Superior Court in Glosser Bros. held that the trial court should not have totally disregarded the market trading price. By its ruling, the Superior Court attempted to pull away from the holding of O’Connor, in which the Supreme Court held: “[Shares of] a closely-held family corporation having unlisted stock and … no public market … [are] sold too infrequently for market value to play any part in [valuation].” In Glosser Bros., the Superior Court remanded to the trial court to consider market value among other valuation methods.

In Part II, which will be posted next week, we will discuss the other issue raised by Glosser Bros.: the expert’s ability to give opinions based upon hearsay evidence of the type ordinarily relied upon in the practice of business valuation.

A recent edition of Value Matters, a periodical published by Mercer Capital Group, illustrates the reasons for having a buy-sell agreement and what options might be available. Buy-sell agreements are advisable for the same reason as prenuptial agreements: they structure the consequences of a possible future incident such as shareholder disharmony, death, or divorce.

The valuation provisions of a buy-sell agreement, which may dictate the share price in the event of partner withdrawal, death or divorce, must reconcile competing concerns. On one hand, a book value formula might be desirable in the event of divorce or the buyout of a withdrawing shareholder. On the other hand, a below-market share price may result in excessive estate taxes for the beneficiaries of a deceased shareholder. An agreement can provide different formulas for different situations, but must presumably reconcile those inconsistencies or suffer close scrutiny of the courts or IRS.

Trigger events, valuation method, and purpose are some of the important elements of a successful buy-sell agreement. Extensive details are provided, presumably, by Chris Mercer’s book, Buy-Sell Agreements.